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The right way to break up with your credit card

Stephanie Skinner
Stephanie Skinner

Stephanie Skinner recently received one of those letters that credit card account holders dread; her 11 percent rate had been raised to 29.99 percent. And when she called Citibank to complain, she was placed squarely between a rock and a hard place.

Accept the higher rate, she was told, or close the card and accept the damage to her credit score.

"I said to them, 'You're giving me the option to either shoot myself in the foot or shoot myself in the hand. That's just unacceptable,'" said Skinner, from Greenville, S.C.

She holds only two credit cards, so the hit to her credit score from closing one would be significant.  "What am I supposed to do?" she wondered.

It's a frequent question for American consumers these days.  Half of all account holders say they've been hit either with a higher rate or a lower limit in recent months.  While consumers are customarily given the choice to decline the new terms and close the account, doing so flies  in the face of all standard advice from personal finance experts because closing credit cards usually has a negative impact on credit scores.

"Credit utilization" is one of five important factors used to determine a consumer's score. Closing a card with a $10,000 limit means the consumer has $10,000 less in credit.  If that consumer owes $5,000 on a second card with a $10,000 limit, their utilization just shot from 25 to 50 percent, a credit score killer.

So which bad choice is right for Skinner and other consumers facing the same conundrum? The answer is perhaps even more maddening than the question: "It depends" and "there's no surefire way to know ahead of time." But there are some clear guidelines that can help.

For starters, closing an account will never help your credit score, despite persistent mythology to the contrary.  The only time closing a credit card account is a good idea is when keeping it open will do even more damage than the lowered credit score.

No one can say precisely how much closing a credit card account will hurt your credit score -- too many other dynamic factors go into calculating the number. Fair Isaac, which owns the credit score formula, says the impact can range from zero points to "dozens of points," according to spokesman Chris Groppa.

Dozens of points doesn't sounds so bad, right? Wrong, says Credit.com's John Ulzheimer, himself a former Fair Isaac employee.

"The amount of their score drop isn't as important as whether or not they cross the lines between approved and declined, and better rate or not as good of a rate," he said.  "Example: If my score goes from 685 to 675 then that's only 10 points so no big deal, right?  But what if (the consumer) applied for a car loan and the lender offered 7.9 percent above 680 and 9.9 percent for someone below 680. Then the 10 points become very meaningful. This isn't unrealistic as all lenders use score-tiered decision tables."

In other words, if you are planning to buy a house or a car in the next month or two, closing a credit card is a terrible idea -- even if your interest rate is about to skyrocket.

But outside of that backed-into-a-corner situation, consumers should feel comfortable exercising their right to fire their credit card company and accept the consequences.

"People shouldn't let worry over FICO scores rule their lives," Groppa said.

RED TAPE WRESTLING TIPS

For starters, a higher rate will cost money today for anyone who doesn't pay their balance in full. A credit score drop of 20 points or so might cost you money tomorrow. But you don't know how much, and you don't know how long the credit score hit will last. It's smart to take the sure savings today and close the card.

There are strategies for minimizing the negative impact once you do so. First, carrying a low balance or paying off your cards is the best insurance against the penalty of closing a card, Groppa said. If a consumer closes a card and loses $10,000 in available credit, but pays off $10,000 in debt on other cards, the available credit would remain equal and there would be no or minimal impact on a credit score, he said.

Of course, that's not always realistic. A second route to a similar result is to open new credit cards with limits that replace the lost credit. Opening new accounts can also negatively impact a credit score, but not as much as losing available credit.

Credit.com's Ulzheimer recently had to do just that to protect his credit score.

"Bank of America and Barclays slashed a combined $25,000 in credit limits for me,” he said. “My score went from 809 to 757. I opened two new cards and replaced the $25,000 and added an additional $10,000.  My scores went back up to 790s. So I didn't get back all that I lost, but I will eventually because inquiries and new account damages reduce with time."

Planning ahead works, too. Open the new cards before closing the old, he said. That'll give you more time, and less pressure, while you shop around.

He also recommended getting new credit cards from credit unions instead of large banks, because they aren't "doing the same things that the big 10 (banks) are doing."

Skinner found an even better solution. After a half-day of phone calls, she managed to score a stay of credit card execution: Citibank postponed her rate increase until May 2010, thanks in part to her perfect payment history and a credit score in the high 700s.  That'll give her time to shop around, and also might give Citibank an opportunity to reconsider.

"I'm not a person who accepts no for an answer the first time or even the second time," she said.

For additional discussion on the impact of closed credit cards on credit scores, Fair Isaac has two lively discussion boards devoted to the topic here and here.